Startup ventures are different from traditional lifestyle or small businesses. These ventures provide a repeatable value proposition that has potential to scale. These attributes are necessary to achieve the rapid growth that these businesses target. Securing funding from either loans or equity funding is common practice to reach lofty growth targets. The business will also re-invest all operational revenue into the company. These businesses primarily use funds for research and development and marketing. Without extensive sales and marketing efforts, reaching the growth expectations is nearly impossible. As such, lenders are reluctant to make loans to startups at reasonable rates. In steps the equity investor.
In this article, we discuss the role of equity investment, the exceptions of investors, and when a company should seek equity investment.
The Role of Equity Investors
Startup companies often seek equity funding from outside investors (angel investors or venture capitalists). These investors provide the necessary growth capital in exchange for an ownership interest (equity) in the company. The investor’s objective is to purchase the ownership interest when the company is not highly valued. Once the company undergoes extensive growth, the investor’s ownership interest will have increased in value considerably. The investor can then sell her ownership interest for a profit. The profits are taxed at a capital gains rate, which is generally much lower than normal income tax rates.
Investing in a startup is a risky undertaking. The majority of startups fail, and many do not provide an investor with a return on investment. As such, an investor will only look to invest in a business that has the potential to scale and grow rapidly. They expect many of the startups in which they invest to fail. On average, they need at least one out of ten investment companies to become successful. This one company may yield a 20-30x return on the capital invested. Averaged across all of the investor’s portfolio of investment companies, this will result in the expected rate of return for all investments.
An equity investor is not going to be interested in a company that cannot demonstrate the ability to scale and grow rapidly. Further, the equity investor will want to invest in companies in industries that provide a high return on investment. Startup companies are generally valued based upon active users/clients or monthly, recurring revenue. They are valued at some comparable deal, market, or industry multiple of these performance metrics. Technology startups are usually valued at very high multiples based upon the ease at which they scale. Personal service companies are generally valued at a far lower multiple based upon difficulties in scaling.
Companies seeking equity investment should keep this reality in mind. When deciding on when or whether to seek equity investment, it is important to know what the investor is looking for. An equity investor is not going to provide as much capital or is going to demand a far greater percentage of company ownership for a company that cannot show potential to scale and grow.
When to Seek Equity Investment
Seeking equity investment is a necessary evil for most startup companies. The company founders generally do not like giving away company ownership. Further, the founders do not generally like it when investors begin to exert control over the company. Therefore, the starting point for founders should be to avoid seeking equity investment. If, however, the startup is unable to fund operations or achieve sustainable growth without additional resources, equity investment may be the only option.
If the startup does seek equity investment, it should put it off as long as possible. This will allow the company greater time to demonstrate product-market fit, scalability, and growth potential. As discussed, equity investors will purchase an interest in the company based upon the company’s valuation. Early in the company’s life, it is very difficult to value the company. The company has not begun to scale rapidly, so there are very few metrics on which to base a high valuation. As such, the equity investor generally requires a larger percentage of ownership for her capital than she will at a later stage of growth.
Once a company can no longer meet its operational or growth objectives without additional resources, it is time to seek investment from venture capitalists. Early-stage companies seeking seed capital must generally work with angel investors or angel investment groups. These individuals and groups generally invest amounts that are below $1 million. They generally do not require that the company have significant revenues, but they do require that the company show product-market fit and the potential to scale and grow. These investors also focus on the value of intellectual property held by the company and the expertise of the founding team.
If the company is at a later stage of development and is seeking more than $1 million to meet the next 18-24 months of growth targets, the company should look to venture capital groups. These groups will generally invest between $500 thousand and $5 million dollars in a single company, in a single round. They generally only invest in companies with strong performance metrics. This can be large numbers of recurring clients/users or specific revenue targets. If the company performance meets their criteria for growth potential and future value, the investors will be interested in negotiating an investment deal.
LawTrades Knows Equity Investment
The moral of this story is to show potential before seeking investment. If the investor senses greater potential in the company, she will be willing to provide more capital at a higher company valuation. This will preserve the ownership interests of the founders and for later rounds of investment. We’re a marketplace of legal attorneys who are experts in matters of venture capital and equity funding. Reach out to see how you can make your company’s equity funding transaction a success.